ASS#3 Draft

British Polythene Industries

Step 1

Ratio Analysis

After calculating ratios for the last four years of my firm I realize that ratio analysis is critical to gain a full understanding of financial statements for many users including investors and managers in making decisions. Because these ratios reflect all the parts of company’s performance including company's efficiency in terms of its operations and management, its ability to use its assets and earn profits, its sufficient liquidity and its reputation in market place.

Profitability Ratios

·         Net Profit Margin = Net profit after tax/sales      3.3%      2.6%      2.9%      2.9%

Profit margin is calculated as net profits after tax divided by sales. I initially confused because I cannot find ‘Sales’ account in my firm’s Income Statement. After discussing with my fellows about my problems I understand that ‘Sales’ is ‘Turnover’ in my statement. Profit margins are expressed as a percentage and, in effect, measure how much out of every dollar of sales a company actually keeps in earnings which varies from year to year. In relation to the net profit margin calculated for Polythene British Polythene Industries, the figures show that the highest net profit margin in 2011 at a rate of 3.3% which means the company has a net income of £0.033 for each dollar of total revenue earned. The ratios decreased slightly in following years with 2.6% in 2012 and the figures remained stable in 2013 and 2014, for every dollar that company earned the firm kept £0.029 of every dollar earned. In 2012, although the firm experienced a decline of 0.7% in net profit margin, they generated higher revenue of £’m507.5.

·         Return on Assets = Net profit after tax/total assets         6.5%      5.2%      6.0%      6.5%

The Return on Assets Ratio (ROA) illustrates how efficient company is at using its assets to create earnings calculated by dividing a company's net profit after tax by its total assets. That tells us how much the return is on every dollar of profit that the company makes on every dollar that is invested into the total assets. These ratios show that my company has generated a rate of 6.5% in 2011 before decreasing to 5.2% and 6.0% in 2012 and 2013 respectively. Then its level of return on assets recovered to 6.5% in 2014. This demonstrates that the higher profit does not directly mean a higher return because the figures for 2011 and 2014 in net profit are different (£’m16.4 and £’m14.8) but they have a similar rate of 6.6% of return for the total amount of assets in the company.

Efficiency (or Asset Management) Ratios

·         Total Asset Turnover Ratio           Sales/total assets             1.99       2.03        2.08        2.24

The Asset Turnover ratio can often be considered as an indicator of the efficiency with which a company is using its assets in generating revenue. In other words, these ratios show how much revenue gained for every dollar invested into assets. The figures demonstrate that the company experienced an upward trend in the amount of asset turnover from 1.99 increasingly gradually to 2.24 in 2014. Actually, the higher the asset turnover ratio, the better the company is performing. Therefore, my company effectively generated revenue from its assets over the period shown.

Liquidity Ratios

·         Current Ratio     Current assets/current liabilities               1.44       1.19        1.30        1.32

The current ratio (liquidity ratio) that present a company's ability to pay their both short-term and long-term obligations considering the relationship between the total assets of a company including both liquid and illiquid (cash, marketable securities, inventory, accounts receivable) and their current total liabilities (debt and accounts payable). The higher the current ratio, the more capable the company is of paying its obligations  A guideline for the current ratio suggests that a company’ current ratio under 1 indicates that its liabilities are larger than its assets and are likely to be unable to pay off its obligations if they came due at that point. Likewise, a current ratio below 1 shows that an unhealthy financial situation. In relation to my company, these ratios are greater than 1 (1.44; 1.19; 1.30 and 1.32 in 2011; 2012; 2013 and 2014 respectively) would suggest that the company seems to be able to pay off their current obligations.

Financial Structure Ratios

·         Debt/Equity Ratio = Debt/equity    543.7%             266.0%                  297.6%                 314.7%

Debt/Equity Ratio is a debt ratio is the measure of a company's financial control, calculated by dividing a company’s total liabilities by its stockholders' equity. The ratio indicates how much debt a company being fund to finance its assets relative to the amount of value represented in shareholders’ equity. My company’s debt to equity ratio shows that there has been a downward trend from 543.7% in 2011 to 266.0% in 2012, 297.6% in 2013 and increased slightly to 314.7% in 2014. This indicates that the company has taken on relatively little debt and thus has low risk.

·         Equity Ratio = Equity/total assets          15.5%    27.3%    25.2%    24.1%

The Equity Ratio tells us the amount of assets that are funded by owners' investments by comparing the total equity in the company to the total assets. This ratio allows companies to determine the areas where they would like to take any financial risks to improve the amount of equity that is allocated to different areas in the business. The equity ratio shows that my company has an unstable amount of equity over the past four years. In 2011, Sky Network Television had a relatively low figure of 15.5% then increased to 24.1% in 2014. These small figures are not healthy ratios because companies with higher equity ratios show new investors and creditors that investors believe in the company which are worth investing and are willing to finance it with their investments. A higher ratio also shows potential creditors that the company is more sustainable and less risky to lend future loans.

Market Ratios

·        Earnings per Share (EPS) = Net profit after tax/nos of issued ordinary shares      

0.60        0.48        0.52        0.56

The Earnings per Share (EPS) Ratio is an indicator of a company's profitability that is distributed to the number of ordinary shares in the company. It is calculated by determining the relationship between net profit after tax and the number of issued ordinary shares. I collected the number of issued ordinary shares from the note for Share premium account in my firm’s financial statement. My company’s EPS has fluctuated by falling rapidly from 0.60 in 2011 to 0.48 in 2012 then rose slightly to 0.52 and 0.56 in 2013 and 2014 respectively. These small figures indicate that my company are unlikely to expect the shares to generate more earnings in the future. Because higher earnings per share is always better than a lower ratio because this means the company is more profitable and the company has more profits to distribute to its shareholders.

·         Dividends per Share (DPS) = Dividends/number of issued ordinary shares           

(0.15)    (0.13)    (0.12)    (0.12)

Dividends per share (DPS) is the amount of dividends that the shareholders receive on a per-share basis. It is calculated using the total dividends paid out to shareholders over one fiscal year and the number of issued ordinary shares. My company experienced a negative amount of DPS in all of the four given years. The figures increased slightly from -0.15 in 2011 to -0.12 in 2014 indicating to my company that the expected share price of dividends is expected to rise in the future.

·         Price Earnings Ratio = Market price per share/earnings per share             

10.95     13.35     7.66        6.04

The Price Earnings Ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings by examining the relationship between the current market price per share and the earnings per share. High P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. my company has experienced a downward trend in the amount of price earnings gradually deceasing from 10.95 in 2011 to 6.04 in 2014 showing the lower expected earnings growth in the company in future.

Ratios Based on Reformulated Financial Statements 

·         Return on Equity (ROE) = Comprehensive Income/shareholders' equity

-58.10%       22.58%           12.26% -11.72%

The Return on Equity (ROE) Ratio shows how much profit a company generates with the money shareholders have invested. The return on equity ratio examines the relationship between the amount of comprehensive income and shareholders’ equity. Over the past four years, BPI Polythene Industries have witnessed a significant increase of 80.68% from -58.10% in 2011 to 22.58% in 2012 before rapidly falling to 12.26% in 2013 then continuously dropping to -11.72% in 2014. These figures show the unstable financial health of my company because when net income is negative, ROE will also be negative. In 2012 and 2013 the ROE level greater than 10% so the company is considered strong and covers its costs of capital. But in 2011 and 2014 the negative ratios show a not good performance of firm with these years.

·         Return on Net Operating Assets (RNOA) = Operating income after tax (OI)/net operating assets (NOA) -31.34%   20.07%  13.07%                -5.70%

The Return on Net Operating Assets (RNOA) a key driver in generating value for a business. These ratio tell us the rate of return on the net operating assets in the company examining the relationship between the amount of comprehensive operating income after tax (OI) and net operating assets. Over the period, my company’s RNOA dramatically rose to 20.07% in 2012 from -31.34% in 2011 before falling by 7% in 2013 and 25.77% in 2014. The figure of RNOA is -5.7% in 2014 tells the company that the earnings under of the net operating assets invested in the business, hence gaining the not good financial position of the company.

·         Net Borrowing Cost (NBC) = Net fin. expenses after tax/net financial obligations              

-20.00%                -18.15%                -17.71%                -10.91%

The Net Borrowing Cost (NBC) Ratio shows the average interest rate the firm is paying on its financing calculated by examining the relationship between the net financial expenses after tax and the net financial obligations. In over four years, BPI Polythene recorded its negative rate of net borrowing of -20.00%; -18.15%; -17.71% and -10.91% in 2011, 2012, 2013 and 2014 respectively. Initially these negative values show profitable situation to the company.

·         Profit Margin (PM) = Operating income after tax (OI)/sales         

-3.86%  3.68%    2.06%    -0.92%

The Profit Margin (PM) Ratio is the measure how much out of every dollar of sales a company actually keeps in earnings which is similar to net profit margin. The profit margin ratio examines the relationship between the amount of comprehensive operating income after tax (OI) and sales. Over the past three years, my company has recorded its highest profit margin of 3.68% in 2012 before gradually falling to 2.06% and -0.92% in 2013 and 2014 respectively. These decreases in profit margin indicate to the company that there is no profit and unable to cover its costs.

·         Asset Turnover (ATO) = Sales/net operating assets (NOA)           

8.13        5.46        6.35        6.18

The Asset Turnover (ATO) Ratio reveals how much revenue the company is generating from each dollar's worth of assets calculated by establishing the relationship between the total amount of sales and the net operating assets. My company’s asset turnover ratio fluctuated over the four years decreasing from 8.13 in 2011 to 5.46 in 2012 before increasing to 6.35 and 6.18 in 2013 and 2014 respectively. Generally, ATO measures how well a company used assets to generate profit so according to these figures, my firm’s performance currently has no improvement.

Economic Profit Analysis

According to the economic profit for over the past four years of British Polythene Industries. The key drivers of my firm’s economic profit are the Return on Net Operating Assets (RNOA), cost of capital and Net Operating Assets (NOA) throughout the formula:

Economic profit = (RNOA – cost of capital) * NOA

Therefore, as I use 10% as my firm’s cost of capital, if the total rate of RNOA is less than 10%, my firm will generate a negative economic profit. If the total rate of RNOA is more than 10%, my firm will generate a positive economic profit meanings they add some value to company. We can see from the figures above, my firm generated negative economic profit -25.4 in 2011 and -12.9 in 2014 due to -31.34% and -5.70% in the rate of RNOA respectively. And they generated positive economic profit 9.4 in 2012 and 2.3 2013 with the rate of RNOA are 20.07% 13.07% respectively.

As a result, in order to create value for firm with positive economic profit, the rate of RNOA must exceed the cost of capital. In addition, the two key accounting drivers of RNOA are PM and ATO (PM=PM*ATO). Therefore, the company’s negative economic profit is the result of the decreasing of PM and ATO. Over the past four year, the figures for ATO are positive so the negative in the rate of PM in 2011 (-3.86%) and 2014 (-0.92%) result in the company’s negative economic profit. Some causes of negative PM can be higher supplier costs as my firm’s resource constraints are polymer, and higher cost of energy, lower prices and intense competition. In order to achieve the final profitable objects of company, they should take some implemented solutions such as analyse profit margins by finding out the gross profit margin on each of products and services over different business divisions, product categories, suppliers or customer categories to identify both low margin or loss-making items and profitable activities or products to stop selling low margin lines and focus on the ones that work, increase and review prices, no discounting too much, take cash discounts from suppliers, prevent theft and use inventory systems effectively.

Step 2

British Polythene Industries has two options for a capital investment which are new manufacturing plant in Melbourne and Wellington in 10 years and 7 years respectively. In order to decide the most profitable capital investment option to BPI, I focus on examine the Net Present Value (NPV) and Internal Rate of Return (IRR) which help to predict these options’ outcomes. Throughout my calculation

In the table below are the original cost, expected future selling price, estimated life, payback period, NPV, IRR, the estimated future cash flows and cumulative cash flows for each investment option.

               

	Manufacturing in Melbourne	Manufacturing in Wellington
Original Cost	$250,000	$135,000
Estimated life	10 years	7 years
Estimated future cash flows
2017	30,000	15,000
2018	68,000	18,000
2019	68,000	21,000
2020	12,000	26,000
2021	90,000	26,000
2022	88,000	28,000
2023	6,800	30,000
2023	7,800
2024	8,400
2025	6,900

The investment would be made on 31 December 2016. The estimated future cash flows are expected to be received on 31 December of each year.

A positive net present value indicates that the projected earnings generated by a project or investment (in present dollars) exceeds the anticipated costs (also in present dollars). Generally, an investment with a positive NPV will be a profitable one and one with a negative NPV will result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that the only investments that should be made are those with positive NPV values.

These two options differ in initial investment, future life and cash flows. Net present value (NPV) indicates how profitable a predicted project is in present dollars. Melbourne has a larger amount of investment and higher expected future cash flow than the Wellington investment. The Melbourne also is expected to return a positive NPV of $11,664.17 while the Wellington is forecasted to produce a negative NPV of -$25,607.67. The internal rate of return (IRR) is the rate of growth that the project is predicted to achieve. The IRR for Melbourne (11.31%) is two times greater than the figure for Willington (5%). The Melbourne’s payback periods is also shorter than Wellington with 4.8 years for option 1 and 6.033 years for option 2.

According to the calculated figures, option 1 taking a new manufacturing plant in Melbourne should be chosen by the company because it has a positive NPV that can produce more income, better IRR and payback period than the option 2 has a negative NPV which is expected to lose money and the lesser IRR and longer payback period.

Throughout analysing of the two capital investment options I found some strengths and weaknesses. Determining the NPV is the better method of the three because it is easy to calculate and take ‘time value of money’ into account while payback method easy to understand but does not take ‘time value of money’ into consideration. In addition, I found that estimating a timing of cash flow is difficult to predict.